What is Convertible Securities?

Convertible Securities are financial instruments which can be converted into different securities which have a different nature or working or different terms for redemption. Basically, it takes the form of a different type of security after the term of conversion is ended. The term and the obligation of both the parties i.e. shareholder and the company are changed after the security is converted into a different financial instrument.

Types and Components of Convertible Securities

The different types of convertible securities

#1 – Convertible Bonds

Convertible bonds are those that convert into a fixed number of shares of the issuing company usually at the time of their maturity. Thus, such bonds have features of equity as well as debt.

#2 – Convertible Preferred Stocks

Preferred stocks are those kinds of common shares which get preference over equity shareholders and convertible preference shares are those which are paid a dividend at a fixed price or a percentage and which get preference over the common equity shares at the time of liquidation. They are convertible in nature in the sense that preference shares can be converted into common equity shares as per the terms and agreement and the nature of the instrument which is issued by the company.

Convertible Securities Calculation with Examples

Let’s see some simple to advanced examples of convertible security to understand it better.

Example 1

Company XYZ is engaged in the service industry and has a $1,000 par value bond which is convertible into common stock. It has a coupon rate of 5% which is paid annually. The bond prospectus specifies a conversion ratio of 30. How many shares will a shareholder get if he has invested $1,000 in the company?

Solution:

The conversion ratio is given in the problem which is 30 which means that the investor will get 30% worth of shares in proportion of his shareholding of the bonds.

So the problem can be solved with the following steps:

Worth of common shares that the investor will get = $1,000 / 30 = $ 33.34

Example 2

Company Dilip Buildcon is engaged in the construction industry and has a growing presence in the markets of the middle east and northern Africa. The company has a $3,000 par value bond which is convertible into common stock. It has a coupon rate of 5% which is paid annually. The bond prospectus specifies a conversion ratio of 50. How many shares will a shareholder get if he has invested $3,000 in the company?

Solution:

The conversion ratio is given in the problem which is 30 which means that the investor will get 50% worth of shares in proportion of his shareholding of the bonds.

So the problem can be solved with the following steps:

Worth of common shares that the investor will get = $3,000 / 50 = $ 1,500

Advantages of Convertible Securities

It gives advantage to the investor which converts the risk of the security from one instrument into another. For example, if the investor has a bond and it is convertible into equity security then the investor is into a better position to earn a return on its investments.

It also gives flexible options for lower interest payments in case it is convertible into common shares and has lesser maturity tenure.

Tax advantages are also there in case of convertible securities.

Disadvantages of Convertible Securities

One disadvantage is that financing with convertible securities runs the risk of diluting not only the EPS of the company’s common stock but also the control of the company. Hence investment banker who is running the issue faces a hard time to raise money from the banks for the company.

Conversion of securities into common equity also has the risk of voting rights as it leads to a dilution of voting rights among a larger group of shareholders which in turn results in dis-ownership of the founders of the company.

Conclusion

There are pros and cons to the use of convertible security for financing; investors should consider what the issue means from a corporate standpoint before buying in also they should consider the financial situation of the company before going for a subscription of a convertible security. Investors should thoroughly review the bond prospectus before investing.

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